Inflation expectations may remain tempered for the next few years, allowing corporate bond prices to continue their ascent. In the Federal Reserve minutes released last Wednesday, policymakers began laying the groundwork for an eventual withdrawal from easy monetary policy. No final decisions were put into place, but the Fed made it clear that it was only engaging in "prudent planning" and did not signal that it was ready to "normalize" monetary policy by raising interest rates.
Weak labor market justifies low rates
Minneapolis Fed President Narayana Kocherlakota said in an interview with CNBC, prior to the release of the Fed Minutes, that he did not think the Fed's preferred measure of inflation would reach 2% until 2018. This in essence made an argument for leaving loose monetary policy in place.
Sluggish wage gains were cited as an indication that the labor market could be weaker than the nation's 6.3% jobless rate suggests, holding down inflation growth. "Wage growth is probably not going to have much impact over the next year or so because wage behavior at the moment is benign and there is very little tendency for wages to rise except in certain sectors where there are skill shortages," Stephen Lewis, chief economist at Monument Securities, told Reuters.
Some policymakers reported, however, that "labor markets were tight in their districts or that contacts indicated some sectors or occupations were experiencing shortages of workers." This could easily make the case for higher inflation and increased interest rates in the near term. Either way, inflation as measured by the Consumer Price Index is expected to average 1.8% this year, below the Fed's 2% target. So long as the Fed remains cautious and there is slack in labor market health, inflation expectations should remain low.
Impact on corporate bonds
The market's perception of U.S. inflation has been weak since last summer, when previous Fed Chairman Ben Bernanke hinted at ending monetary stimulus. His comments led to a broad sell-off in both equity and bond markets, moving up the time frame for the raising of the benchmark rate. Higher rates would cut growth and stop any form of price increases. As the Fed has attempted to backtrack after those comments and promised that actual rates would not be raised for months or even years after its stimulus program ended, funds have begun to flow back into corporate bonds.
iShares Barclays Aggregate Bond Fund (AGG +0.13%) has risen from its late-2013 lows to yearly highs this month.
The market does not view rising inflation as a credible threat to bond prices, yet it knows the Fed is unlikely to raise its benchmark rate until at least 2015. This dynamic could continue to fuel the rally in corporate bonds and make them a preferred investment to equities, especially as many equity investors question the stock market's lofty valuations -- the S&P 500 sits near a record high.
The next Fed policy meeting will be in mid-June, when the panel will have a better idea of how economic growth and the labor market are progressing in the second quarter. Expect the Fed minutes from that event to be equally watched and impactful on markets, considering data will be perceived as better representing the U.S. economy.
